Updated Federal Ministry of Finance’s circular on the treatment of income from employment under double tax treaties

On 12 December 2023, the Federal Ministry of Finance published the fourth version of its circular on the tax treatment of income from employment under double taxation treaties (DTTs) (hereinafter the “Circular”). The revision focuses on consolidating various Federal Ministry of Finance circulars and integrating current case law, but also provides specific in-depth comments on subjects like the treatment of signing bonuses (see point 9. below) and new opinions on topics like working from home (see point 15. below).

The tax authorities’ efforts to offer a clearer overview of the various official statements and increase legal certainty for users, as seen especially by the inclusion of additional examples, are to be welcomed, especially in light of the complexity of the topics.

The Circular is intended to apply to all open cases and replaces the circulars dated 3 May 2018 and 22 April 2020.

The relevant adjustments can be summarised as follows:

1. Limitation of the priority of DTTs by the Tax Haven Defense Act (Steueroasen-Abwehrgesetz, StAbwG)

The German Tax Haven Defense Act has introduced a treaty override in sec 1 para. 3 sent. 2 that provides that DTTs cannot limit Germany’s domestic taxation rights when the other contracting state is a non-cooperative tax jurisdiction. The Federal Ministry of Finance has implemented and clarified this requirement (mn. 6) and named Trinidad and Tobago as an example (mn. 407).

2. Residency

The Federal Ministry of Finance elaborates on its previous statements and points out that residency for DTT purposes must always be examined independently. Neither a Certificate of Residence, nor tax treatment in the other contracting state is relevant (mn. 7). In this context, it is furthermore made clear that residency for DTT purposes and domestic tax liability are to be examined independently of one another (mn. 8). This distinction is logical since they relate to two different nexus.

Furthermore, the Federal Ministry of Finance regards Art. 4 para. 1 sent. 2 of the OECD Model Convention on Income and on Capital (hereinafter the “OECD MTC”) as declaratory. It provides that a person is not a resident for tax purposes of a contracting state if only source taxation applies in that state. Residency for DTT purposes therefore only applies to individuals who are taxed on the basis of their world-wide income in Germany, whether or not the applicable DTT includes a provision corresponding to Art. 4 para. 1 sent. 2 of the OECD MTC. However, a deemed unlimited tax liability (fiktive unbeschränkte Steuerpflicht), as is provided for in sec. 1 para. 3 of the German Income Tax Act (Einkommensteuergesetz, ITA), is not sufficient to establish residency for DTT purposes (mn. 9).

In cases of dual residency and where a person's centre of vital interests has to be determined, the Federal Ministry of Finance assumes that personal and economic ties should be given equal weight when carrying out the necessary evaluation of these two criteria (mn. 14). The catalogue of relevant personal or economic ties has been significantly widened, with distinctions now made between income and assets with regard to economic ties (mn. 15, 16). This will provide legal practitioners with significantly more guidance than before.

Regarding personal ties, the Federal Ministry of Finance upholds the rebuttable presumption, already expressed in the existing examples, that for secondments of up to one year, an individual’s personal ties remain in the state of their usual living place. Conversely, for secondments exceeding five years, the opposite is presumed to apply (mn. 18). In addition, further examples to assist in determining residency are provided in marginal numbers 19 to 23.

3. Definitions: salaries, wages and similar remuneration

In the opinion of the Federal Ministry of Finance, the terms “salaries, wages and similar remuneration derived from employment” under DTT law should be interpreted in accordance with the lex fori rule in Art. 3 para. 2 of the OECD MTC and be based on the national tax law of the state applying the treaty. In Germany, sec. 1 and 2 of the Wage Tax Implementing Ordinance (Lohnsteuer-Durchführungsverordnung, LStDV) are relevant for this (mn. 28). The Federal Ministry of Finance also refers to sections H 19.0 to H 19.2 of the Wage Tax Guidelines (Lohnsteuerhinweise, LStH) on the distinction between income from self-employment and employment.

4. Remuneration of partners of a partnership for activities in the service of the partnership

The Federal Ministry of Finance has added statements on the treatment of remuneration of partners of a partnership for activities in the service of the partnership (mn. 32 ff.). The treatment of such remuneration was already based on sec. 50d para. 10 ITA and the Federal Finance Ministry circulars of 26 September 2014 (application of DTTs to partnerships) and 10 November 2021 (corporation tax option pursuant to sec. 1a of the Corporate Income Tax Act (Körperschaftsteuergesetz, KStG)).

5. Expiry of the limitation period for assessment is not a waiver of taxation

The tax authorities have adopted the Federal Finance Court’s (Bundesfinanzhof, BFH) previously unpublished judgment of 10 October 2018 (I R 67/16), according to which the expiry of the time limit for a foreign country to assess taxes does not constitute a waiver of taxation within the meaning of sec. 50d para. 8 sent. 1 ITA (mn. 69).

6. Limitations on deducting pension expenses

The Circular also contains changes to the statements on handling limitations on pension expense deductions, in particular it addresses the possibility of taking into account pension expenses that are directly economically related to employment income originating from EU/EEA countries or Switzerland (mn. 95). However, these changes do not provide any new insights beyond those already codified in sec. 10 para. 2 sent. 1 no. 1 ITA.

Furthermore, the Circular now contains an illustrative example how to allocate deductible and non-deductible pension expenses in relation of the taxable remuneration to the total remuneration (mn. 96 ff.).

7. Employee secondment

The comments on the secondment of employees in the Federal Ministry of Finance’s circular of 9 November 2001 have been incorporated in the present Circular. As a result, the Circular now contains, for example, a definition of what constitutes a secondment and what is excluded (mn. 149, 150), comments on the company’s operational interest in the secondment, including the factors that are indicative of this (mn. 159, 160) and the effects of a rotation system (mn. 174, 175). What is also new is that employers are required to certify to their employees the amount of remuneration, employee-related expenses and payroll administration costs passed on in accordance with the arm’s length principle and the amount of these costs borne by the company sending the employee (mn. 167). This certificate establishes a rebuttable presumption that the costs listed are in line with the arm’s length principle (mn. 167).

In relation to executives, such as managing directors or board members, the Circular takes into account the Federal Finance Court’s judgment of 4 November 2021 (VI R 22/19). According to this judgment, a domestic company can also be the (economic) employer of an executive even if no separate remuneration has been agreed for the work at the domestic company, or if the work is to be specifically performed without a charge, and the part of the salary that is attributable to the executive’s work at the domestic company is already included in the total salary abroad (mn. 178).

8. Principles for determining taxable/tax-exempt remuneration

The Federal Ministry of Finance has introduced punctual changes to the principles for determining taxable and tax-free remuneration. Employees can now provide evidence of their work activities in another state by submitting a travel diary (mn. 225). Furthermore, the Federal Ministry of Finance has now provided specific examples of expatriation allowances, which are directly attributable remuneration components (mn. 227).

9. Signing bonuses

The revised Circular provides more comprehensive rules on signing bonuses (mn. 249 ff.). Unlike the previous administrative direction, the new Circular now distinguishes between repayable and non-repayable signing bonuses that are granted for a specific job yet to be commenced. For repayable signing bonuses, the right to tax is determined based on the places where the work is performed during the vesting period. However, for non-repayable signing bonuses, there is no vesting period, which is why the right to tax remains with the state where the employee resides. Fixed-term employment contracts are an exception to this rule because, in these cases, it is generally not possible to terminate the contract in advance. The vesting period is then the contract term.

The Federal Ministry of Finance still has not clarified how to categorise signing bonuses that are intended solely as an incentive for an employee to sign an employment contract. Clarification in this regard from the Federal Ministry of Finance in the course of future amendments to the Circular would be helpful.

10. Stock options

The updated Circular takes into account recent developments favouring employee stock options. This is reflected in the reference to the introduction of sec. 19a ITA (mn. 278). However, the tax-free amount pursuant to sec. 3 no. 39 ITA mentioned in marginal number 278 is already outdated due to a recent change in the law (the amount is now €2,000 instead of €1,440). It is encouraging that a further example for determining the taxable component of employee stock options has been introduced to help practitioners better understand how taxes on employee stock options are calculated (mn. 288).

11. Phantom shares

The Federal Ministry of Finance has commented for the first time on the treatment of phantom shares (mn. 290 ff.). According to the Circular, the allocation of virtual dividends should follow the general principles for remuneration that cannot be directly allocated (mn. 292).

12. Tax equalisation mechanisms

The content of this section has been revised and expanded to include even more examples. A distinction is now made between tax equalisation and tax protection (mn. 317 ff.). It is pointed out for the first time that the principles also apply to social security contributions assumed as part of a net salary agreement (mn. 323). The test sequence has also been modified. Previously, the first step was to check whether there was an employer obliged to withhold wage tax pursuant to sec. 38 para. 1 ITA; now, the first step is to check whether there is a net or gross remuneration agreement (mn. 324 ff.).

13. Secondment allowances

The Circular now addresses the treatment of secondment allowances for the first time (mn. 339). In general, these allowances are considered salary components that can be directly attributed to the state of the host company if they are intended to compensate the employee for the costs and difficulties of living in the host company’s country. However, if the allowances are remuneration for work performed for the host company, they are considered compensation that cannot be directly attributed to secondment and must therefore be apportioned.

The Federal Ministry of Finance presumes that remuneration cannot be directly attributed to a secondment if the secondment allowance is granted even though the employee remains in their country of residence for several months (e.g. home office). This presumption is understandable as it is unlikely in these cases that the allowance is compensating the employee for the difficulties of living in another country.

14. Assumption of tax consultancy costs

Marginal numbers 345 and 346 of the Circular adopt the Federal Ministry of Finance’s circular of 22 April 2020, which itself supplemented the previous circular of 3 May 2018. However, there are no changes in this respect.

15. Home office

In an endeavour to reflect the increased prevalence of employees working from home in cross-border situations, the Federal Ministry of Finance has laid down some basic rules in marginal number 350 and following and included an example to illustrate them. Where there is a mix of home- and office-based work within one day, the work should, for example, be divided on a pro rata temporis basis. This approach by the tax authorities is consistent with the treatment of professional drivers who work in several countries within a single working day (mn. 384) and is therefore logical.

Ultimately, however, the Circular notes that, except for certain DTTs, in absence of specific rules, the general rule of apportioning remuneration on the basis of actual working days applies. Marginal number 360 provides a specific example illustrating a special feature of tax treaty law for managing directors who work from home under the DTT with Austria. According to Art. 16 para. 2 DTT Austria, the right of taxation lies with the contracting state where the employing company is based, irrespective of the number of days the managing director works from home.

16. Employer-funded pension

The comments on employer-funded pensions now included in the Circular are mainly based on the Federal Ministry of Finance’s circular of 12 August 2021. The declaration that remuneration can be considered to arise during the savings phase in the case of external employer-funded pensions, while this is not the case for internal pensions, is therefore not new (mn. 378). The distinction is nevertheless relevant because when taxation occurs only in the pay-out phase, the right to tax is not generally based on Art. 15 of the OECD MTC, but rather is derived from Art. 18 or Art. 21 of the same Convention (mn. 379).

17. List update and miscellaneous topics

In the list of DTTs, the DTT with Saudi Arabia (Aviation) has been updated with regard to personnel on ships and aircraft (mn. 416 f.).

The list of DTTs containing reversion clauses has also been updated to 1 January 2023. In addition, for the first time, the DTT with the Netherlands includes an example of how a reversion clause is applied (mn. 421).

In addition, reference is made to the option for employees and employers to request a preliminary consultation procedure pursuant to sec. 89a of the Fiscal Code of Germany (Abgabenordnung, AO) for a fee. This consultation aims to provide legal and planning certainty at an early stage before the envisaged events occur (mn. 425).